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Money Markets

In these times of infl ation and the receding prospect of growth, and in the presence of fi scal laxity and higher government borrowing requirements, Indian banks are fi nding it diffi cult to expand their credit portfolio. Moreover, as returns on their investments tend to be lower than those on their advances, in this present overall context the real challenge is in fi nding the right balance as between liquidity, capital and return.

The Reserve Bank of India's monetary policy for 2012-13 has had to be framed at a time when the economy is facing multiple risks - infl ation at an elevated level, a deterioration in the external sector and fi scal laxity. The RBI's aggression in cutting the repo rate by 50 bps is therefore inexplicable. The posture taken by the RBI is fraught with the risk of fuelling infl ation rather than propelling growth, meeting government borrowing at a lower cost rather than providing a fi llip to investment demand and of exacerbating the weaknesses surfacing in the external sector.

The postponement of fi scal consolidation, as is evident from the Union Budget, 2012-13, is likely to add pressure to the external sector balance and enhance the risk of managing the trade-off between infl ation and growth. This note addresses some of these and related issues.

An attempt is made here to reclassify the commodities covered by the Wholesale Price Index series, first, into two groups, namely, the consumer and non-consumer items, and then further split them into convenient subgroups, and analyse inflation behaviour since April 2005 after dividing the period into increasing and decreasing phases of WPI inflation. The analysis throws up interesting results and provides important lessons.

This review analyses the trends in certain crucial parameters pertaining to the market borrowings of the centre and the states. It argues that the latter have made efforts to contain their borrowing. But, continued excess borrowing by the central government is introducing a perverse incentive for the states, which would adversely affect overall fiscal management at the country-level.

Before the global financial crisis, central bankers depended mainly on interest rates in policymaking and operations; in the post-crisis period when liquidity became a binding constraint, liquidity management assumed an equally important place. In India, ever since 2001, liquidity management has been playing an equally important role along with interest rates as part of the operating framework of monetary policy under what is now called the augmented multiple indicator approach. In the present context the Reserve Bank of India should continue to exercise a tight leash on liquidity, but at the same time ensure that the flow of credit to industry and other economic activities is revived.

Deregulation of the interest rate on savings bank deposits will allow more room for non-price competition for improving the quality and diversification of customer service rather than result in a rate war. Given the nature of savings bank deposits vis-à-vis other deposits, some further regulatory guidelines would be required to complete the rationalisation of these accounts. It is the category of current account deposits in the current plus savings bank deposits segment that essentially determines the differences in the cost of funds between banks.

Is the mid-year monetary review by the Reserve Bank of India going to see a pause in the rate hike, implying that policy rates have now peaked? This note tracks the past experience with policy rate movements and identifies the inflection points for rate changes and the nature and intensity of changes in response to inflation and growth behaviour. An attempt is also made to ask what the RBI's stance should be, given the policy dilemma and risks associated with different policy options.

A review of fiscal developments during the current financial year, an assessment of the possibility of failure to achieve the fiscal deficit target, and, in case of a slippage, an examination of its implications for interest rates in the latter half of the financial year.

The downgrade of US debt is the second shock to hit the Indian financial markets after the 50 bps hike in repo rates by the RBI on 26 July 2011. While concerns have been raised about the resulting impact on financial markets and economic growth, an analysis reveals that except for the foreign exchange and the equity markets, the impact of the downgrade so far has been muted on all fixed income markets including the money market. Further, inward capital flows are likely to regain buoyancy in the coming months and the near and medium-term outlook for growth and financial stability should remain intact. Given the persistent demand pressures from the private, public and export sectors, and the downside risks to sustenance of capital flows, the appropriate policy stance for the central bank would be to persevere with its anti-inflationary stance.

Despite the series of policy rate hikes and the corresponding hike in lending rates, the demand for bank credit seems to be robust. The banking system should be allowed to meet this demand in a non-disruptive way without fuelling inflationary pressures. Higher interest rates do not seem to be a deterrent to credit growth since the demand for credit is fuelled by economic activity and banks find their own way of handling additional risks. It would therefore be prudent for the Reserve Bank of India to continue with its anti-inflationary stance and the tightening of monetary policy. However, the pattern of credit growth suggests the need for redistribution in favour of agriculture and exports.

The expansion in the life insurance sector in the post-deregulation period has seen a disproportionate growth of unit-linked insurance plans. However, ULIPs have little value in promoting long-term savings. Moreover, if the insurance and pension sectors are to support infrastructure investments and the development of the corporate bond market, then life funds, rather than short-term investment products, should be the preferred instruments. Given that insurance companies and mutual funds operate under different regulatory regimes with separate prudential norms, the Financial Stability and Development Council should constitute a joint forum between the Securities and Exchange Board of India and the Insurance Regulatory and Development Authority that will focus upon orderly development of MFs and ULIPs.

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